What happens if you die before taking your pension benefits?

March 25, 2015

Firstly, please accept our apologies for coming over all morbid, but this is an important question.

Obviously, when you’re saving into a pension it’s in the hope that you’ll get to enjoy the fruits of your labour over a long and happy retirement. But, sadly, that’s not going to be the reality for some people. And if you do die before you’ve used up your pension pot, it sucks to think that your loved ones won’t get to make the most of your money instead.

Fortunately, the situation is set to somewhat improve for people with a defined contribution pension (so this covers most personal pensions and some company pensions). From April 2015, the so-called ‘death tax’, which saw the government take 55% of pension pots on death in certain instances, is being scrapped. You can read more about the Death of the Death Tax in our earlier article.

What happens if you die and have a final salary pension?

The situation is somewhat different for those who have a final salary, or defined benefit, pension, so we thought we should take a quick look.

All defined benefit schemes have a different take on what will happen to your pension if you die. Generally there is a 50% spouse’s pension, but sometimes the calculation is less generous once you leave the employer and become deferred. It might even end up being as little as 30% of your pot which is actually available to your spouse or partner.

Let’s take a look at a quick example, so you can see to potential impact of such unfavourable terms:

Michael had a final salary pension with his employer, but he got a new job and moved on. On leaving the scheme he became a deferred member of that pension scheme and he’s entitled to a final salary pension of £40,000 per year. A decade later and Michael’s interested in what his old pension is now worth. It turns out the pension had grown to £50,000 a year thanks to compound interest. Nice one. The transfer value is just over £1,000,000 and critical yield is around 6%.

At this time, if he’d died before reaching retirement age, his wife would have received a pension of just £15,000 per year because of the complicated calculation that this particular scheme was working under.

That’s pretty rubbish compared to the £50,000 a year that Michael’s pension had earned for him. Simple maths says that his wife would have had to live for another 71 years to get back to full pot of £1,067,000. Not impossible, but rather ambitious perhaps.

So what’s the answer?

In Michael’s case one option could be to transfer the £1,000,000 into a self-invested pension plan (SIPP). That way, if he dies before retirement age, his wife would receive the full £1,000,000 in cash, tax free. She’d then have two options. She has the freedom at this point to withdraw the cash and put that money in a bank account. If it earns 1.5% she’d be earning that £15,000 per year in interest alone. The other option is to leave money in the pension plan and take tax free withdrawals as and when required. Either way, she’s a whole lot better off than should would have been had the funds been left in the final salary scheme.

Now obviously, the answer isn’t going to be the same for everyone. Different pensions have different conditions attached to them and people’s situations are different. Transferring your pension out of a final salary pension may not be the right answer for you. And it would be a big mistake to make a decision to transfer our of a final salary scheme based on available death benefits alone. There are lots of other things to consider, such as loss of guaranteed income, possible charges, and other aspects of your own personal situation which could override any possible improvement in death benefit by doing so.

But this example demonstrates the vital importance of understanding exactly where you do stand with your current pension in case of death. There may be better options available to you.

And there’s one other biggie to consider…

What happens if you die AFTER purchasing an annuity?

This is where things can take a bit of a disappointing turn if you’re not careful; we touched on this in our article on annuities. Say you’ve bought an annuity with your pot of £1million. This will buy you an income of around £30,000 per year until you die. BUT if you die after a couple of years, in many cases, your pension dies with you. Your spouse, partner or beneficiary gets nothing.

There are measures you can put in place to protect your loved ones in this instance, but you’ll need to decide at the point of taking out your annuity if you want to choose one of these options:

  • Take out a joint life annuity – your income (or a proportion of it) will be paid to your dependant if they outlive you
  • Choose a guaranteed period – your income is guaranteed for a set number of years. If you die before that period is up, the income will be paid to your beneficiary instead for the remainder of the guaranteed period
  • Build in an annuity protection lump sum (value protection) – on death, the fund used to buy the annuity, less income already paid, can be paid out as a lump sum, either tax free or subject to tax depending whether you die before or after age 75.

In summary…

We can’t possibly cover every possible eventuality in one article. There may be alternatives to an annuity which offer you better benefits on death. The main message is that this IS something you need to consider when you decide what to do with your pensions.

Death, like taxes, is inevitable so it makes sense to plan for it now to make sure your loved ones aren’t at risk of being short changed.

 

This article is for general use only and is not intended to address your particular requirements. It should not be relied upon in its entirety and shall not be deemed to be or constitute advice.

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